New Idea for Unwinding Big Banks May Be as Hard to Sell as It Is to Pronounce

WASHINGTON — In the absence of global resolution rules, a hard-to-pronounce buzzword has crept into the debate on winding down big banks: subsidiarization.

The concept, which has been practiced to some extent in other countries, broadly means giant firms putting their many international business lines into clear-cut subsidiaries instead of less distinct branches, making it easier to unwind them in a resolution.

The topic drew attention earlier this month at a Federal Deposit Insurance Corp. roundtable on the agency's new resolution powers, and officials sounded interested in the idea. After last week's summit of the Group of 20 nations failed to produce any other formal process for resolving multijurisdictional firms, observers said subsidiarization, despite its drawbacks, may gain more traction.

"If you cannot come up with a satisfactory cross-border resolution regime for branched and complex institutions, then subsidiarization is your default choice, even though it's understood to be a costly and problematic one," said Karen Shaw Petrou, managing partner at Federal Financial Analytics Inc.

Resolution agencies face all sorts of problems with large firms, including their complexity and the difficulty in distinguishing between their many parts. When a firm has different parts in multiple countries, each with its own financial laws, the job becomes even more taxing.

Many observers said that with subsidiarization, regulators would have a better grasp of where one business line ends and another begins. In cases where multiple governments are responsible for an institution, subsidiarization could help regulators know their roles and give host countries more authority over subsidiaries operating inside their borders.

"The difficulty is having the same legal entity operating different branches in different countries that are therefore subject to different rules," said Bradley Sabel, partner at Shearman & Sterling LLP and a former official at the Federal Reserve Bank of New York. "It would be virtually impossible for the FDIC to liquidate a major U.S. bank with other branches in a foreign country. Having them as separate subsidiaries would make that a lot easier."

But the idea has many skeptics, including those who have seen it in practice. They say big firms need the ability to run top-down organizations, with the flexibility to spread capital and liquidity around to entities with changing needs. That is harder when subsidiaries, which typically have their own capital structures and board management, are siloed.

"The rationale of there being a firewall makes some sense. But on the other side of the coin, it could also mean greater barriers to supplying capital from a parent company to a subsidiary that needs it," said Heath Tarbert, a senior counsel at Weil, Gotshal & Manges LLP and a former counsel to the Senate Banking Committee. "While the firewall may protect the fire from spreading, it could have the unintended effect of ensuring that the subsidiary burns."

Resolution planning has taken on new significance as the FDIC and other regulators implement provisions of the Dodd-Frank Act. In addition to giving the FDIC power to clean up failed behemoths — stemming the kind of chaos that followed Lehman Brothers' collapse — the law tasks the FDIC and the Federal Reserve Board with crafting standards for the wind-down plans firms themselves must give to the government.

At the FDIC roundtable on Nov. 4, the second such meeting on its new resolution authority, FDIC Chairman Sheila Bair indicated that, without global standards on cross-border resolutions, subsidiarization may have merit.

Asking bankers in the room to weigh pros and cons of the idea, she said: "Short of having that type of international framework, how do we resolve international operations now? Obviously, subsidiarization is going to be the easiest thing from an operational standpoint, but I know some of you don't like that idea."

Michael Krimminger, Bair's chief policy deputy, said a firm could arrive at subsidiarization through its own resolution planning, considering which corporate changes make the most sense if it had to be unwound.

"In some ways the resolution planning process will have the effect of making them look very carefully at this among other options, rather than there being a rule that says, 'You have to do subsidiarization,' " Krimminger said in an interview.

While executives at the roundtable agreed the concept has some appeal from a regulator's standpoint, they said it would work counter to how healthy institutions are run.

"Not having the individual operations around the world subsidiarized is the way we think maximizes the firm's ability to maintain the strength of the safety and soundness of the institution, our risk management practices, as well as how we deploy liquidity and other functions across the different business operations," Barry Zubrow, the chief risk officer at JPMorgan Chase & Co., said at the meeting.

To some degree, the discussion about subsidiarization and other methods for resolving cross-border firms has arisen because world governments have yet to develop coordinated approaches similar to the international Basel framework for capital levels.

In the communique from the G-20 summit in Seoul, South Korea, last week, leaders encouraged the continued work of the Basel Committee and the Financial Stability Board to make recommendations about cross-border resolutions, and called on the stability board to "develop attributes of effective resolution regimes by 2011."

Without a coordinated framework, regulators "have a problem they know needs a solution," Petrou said. "The impetus is toward an acknowledged imperfect solution because they can't agree on any other course."

Susan Krause Bell, a former senior deputy comptroller of the currency, said that, as they consider a straightforward answer to their resolution needs, policymakers also have to weigh the possibility of raising the level of risk for open institutions.

"There's a very interesting policy question here, which is do we set banks up in a way that makes their failure clean even if that is less beneficial to ongoing safety and soundness?" said Krause Bell, now a partner at Promontory Financial Group. "In general, you will find industry's position to be that the way they manage their business now gives them more flexibility in terms of liquidity and capital. It can work against a resolution if liquidity gets trapped in a jurisdiction, because everything is organized by subsidiary."

To be sure, subsidiarization is not a new concept. At the FDIC roundtable, participants discussed how certain pieces of Spain's Banco Santander SA operate under a subsidiarization structure. The U.K. has moved more aggressively in the direction of subsidiarization. At one time, Canada had embraced it, but under pressure from firms and other countries, began allowing branch banking.

Sheryl Kennedy, a former Bank of Canada deputy governor, said subsidiarization has pros and cons. She noted it not only increases costs for banks, but regulators conducting a resolution may also want the flexibility to access resources across a firm's other business lines.

"Subsidiarization makes it easier for a regulator who can have a complete, unfettered look and get their arms around the entity that is operating in their country without complicated entanglements," said Kennedy, who now runs Promontory's Canadian operation. "The disadvantage is it's not efficient, and that's not just from the perspective of the financial institution."